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How does the option pool change my valuation?

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In most term sheets the option pool is stated as a percentage of the company after the round closes, commonly 10 to 20 percent, and the pre-money valuation is described as including it. That second phrase is the whole trick. The pool has to be created before the investors' shares are priced, so it comes out of the existing holders' side of the ledger, and the founders are diluted by the full pool while the new investors are not diluted at all. A term sheet that offers a $15 million pre-money with a 20 percent post-money pool is, for the founders, a smaller number than it looks.

The numbers

Take a company with 10 million founder shares, 1 million options already granted and 1 million unissued in the pool, raising $1 million. At a $15 million pre-money with the pool topped up to 20 percent of the post-money, the founders end at about 67 percent. At a $12 million pre-money with the pool at 15 percent, they end at about 70 percent. The lower valuation leaves the founders with more of the company, because the pool that came with the higher valuation cost them more than the extra valuation gave them. This is sometimes called the option pool shuffle.

How to negotiate it

Build a hiring plan instead of accepting a round number. List the people you expect to hire in the twelve to eighteen months the round funds, put a customary grant size against each, and add it up. The total is usually well below the 20 percent an investor calls standard, because the plan reflects your actual hires and the standard reflects other companies. A pool sized to the plan is one investors find hard to argue with, and every point you keep out of the pool is a point that stays with the founders. If the company needs more later, the board and stockholders can enlarge the pool then, at that round's price.

What the pool is for

None of this means the pool is a trick to refuse. Every early hire will expect options, the pool is where they come from, and a company that arrives at its next round with an empty pool will be asked to refill it then. The point is only that the pool is part of the price, and that two term sheets should be compared on what the founders own after the pool, not on the pre-money in the headline.

Written by the lawyers who built Arabella. This is legal information, not legal advice for your situation, and reading it does not make us your lawyers. For a real dispute or a high-stakes decision, talk to a licensed attorney. More questions.